L6_ Practice Problems Direct Regulation Externalities in Ma.docx

L6_ Practice Problems
Direct Regulation Externalities in Markets for goods, services
or Inputs
Ruth Forsdyke
Regulating Negative Externalities:
1) This problem continues on from the L5 and L6 Practice
Problem:
Note: Demand and Supply Curves are hypothetical but roughly
intersect world demand and price
point.
QD(P) = 190 – P
QS (P) = 3P/2 – 60
The marginal external cost is: MCExternal = 25$/bbl (assumed
low carbon tax of $50/tonne CO2e)
The quantity units are in millions bbl oil/day while the price
units are in $US/bbl.
a) Find the marginal Pigouvian tax to regulate this market and
plot on your graph. Illustrate how
this shifts the producer’s marginal cost curve.
b) Starting at the point in time immediately after the tax is
imposed, explain the process by which
the market moves to the new equilibrium.
c) Use areas under curves to illustrate the following under the
tax and indicate whether they rose
or fell:

i) total consumer surplus
ii) total producer surplus
iii) total external costs
iv) total social surplus
v) total tax revenue
d) Find the monetarily socially efficient crude oil quota and
label on your graph.
e) Starting at the point in time immediately after the quota is
imposed, explain the process by
which the market moves to the new equilibrium.
f) Use areas under curves to illustrate the changes in the
following due to the quota:
i) total consumer surplus
ii) total producer surplus
iii) total external costs
iv) total social surplus
v) total quota rent (goes to firms if given away, goes to
government if auctioned in
perfectly competitive market with no corruption, i.e. regulatory
capture).
Variable vs Fixed External Costs:
2) Suppose that you take a return trip by Air from Halifax to
Vancouver and back. The GHGs due
to combustion of the fuel used to power your trip are
approximately 1 tonne of CO2e. Suppose the
price of carbon dioxide is $200/tonne CO2e. This is only part of
your carbon footprint—by taking
the trip, you are also responsible for some very small fraction of
the emission used during the air
plane’s product life cycle and also that of the air port. These
get diluted out over many people and
so your airplane trip still has a carbon footprint of about 1

tonne. Like private costs, external costs
can be either fixed or variable. Identify some variable and
fixed external costs of your trip.
Positive Externalities from Forests:
3) Consider the town of Thneedville. Their monetary marginal
willingness to pay for a truffala
forest is: MWTP = 10 – Q/2 (in millions of $/hectare)
Suppose that the monetary marginal opportunity cost of the
forest is cutting down the forest to
make thneeds is MCPrivate = 10Q (in millions of $/hectare)
Suppose that the forest stores 2000 tonnes of CO2e/ hectare and
that it is estimated that the price of
carbon dioxide is $20,000/ tonne.
This problem is complicated in reality because it takes time to
grow a forest during which carbon
dioxide is sequestered in the soil, plants and other organisms.
When the forest comes into
equilibrium, there will be no net exchange of carbon dioxide
with the atmosphere. For simplicity,
assume the forest grows immediately and all of the above
benefits and costs are in terms of
hectares per century.
a) Find the perfectly competitive market equilibrium quantity
and price of forest and plot on a
graph and label curves and equilibrium.
b) Find the marginal external benefit of forest and plot and label
on your graph.
c) Find the marginal social benefit of the forest and find the
socially efficient price and

quantity. Plot and label on your graph.
d) Label the total external benefit from the forest at the SE level
and calculate it.
e) Label the deadweight loss (i.e. total social surplus loss from
the market).
f) Suggest a quantity and price mechanism by which to regulate
the forest.
g) Which of the quantity and price mechanisms is more likely to
hit the quantity target?
h) Which policy would be easier for government to finance?
4) Suppose that you are considering 3 policies to regulate GHG
emissions from buses. These are
1) a tax on buses, 2) a tax on gasoline and 3) a tax on tailpipe
CO2 emissions from buses. Compare
pros and cons of these policies.
5) List some thneeds that produce positive GHG externalities.
Answers:
a) The marginal tax is equal to the marginal external cost of $25
at the socially efficient quantity.
The producers now pays $25/ barrel to the government
increasing their private costs by $25/ barell.
The supply curve shifts up by $25/ thneed (red to dashed green).
The equation of the new MC
private curve is 65 + 2Q/3 (the same as the social marginal cost
curve).

$/
barrel
Crude oil (millions
barrels /day
PMarket = 100
QMarket
= 90
$MCPrivate_Old
$ MBSocial
A
B C
190
40
0
0 190
$ MBPrivate&Social
$ MCSocial = MCPrivate_New

= $ MCPrivate_Old + $t
PSE = 115
QSE
= 75
D
E
F
H
G
I
J
65 t =
$25/barrel
{Marg. tax
shifts
supply
curve up}
by)
b) Now, immediately after the tax is imposed, at the old market
price of $100/barrel, firms are
willing to supply 52.5 million barrels which is less than the
demand of 90 million barrels so there
is excess demand. The price rises causing demand to fall (move

along demand curve). The new
regulated market equilibrium occurs when new supply = demand
with the new price being $115
and the new quantity being 75 million barrels. This is
monetarily socially efficient.
c) Use areas under curves to illustrate the following under the
tax:
i) The new consumer surplus is equal to A = (190 – 115) * 75
million/2
= Total willingness to pay for 75 barrels – total expenditure on
75 barrels
= [A+B+C+D+ E+F] – [B+C+D+E+F] = A = $ 2812.5 million.
The Tot. Cons. Surplus fell
relative to the unregulated market allocation at which it was
(190 – 100)*90/2 = $4050 million.
ii) The new total producer surplus is equal to B+D which is
equal to the producers’ total
revenue (their variable benefits) – their total production costs
= [B+C+D+E+F] – [ F + E + C] = (115 – 65) * 75/2 = $1875
million.
The old tot. prod. surplus was equal to (100 – 40)*90/2 =
$2700 which is bigger than under the
tax regulation. Hence tot. prod. surplus fell. Note that tot.
prod. surplus is also called “variable
profits” or “economic rent”. Producers profits fall & hence they
may lobby against the tax policy.
iii) tot. external costs = C + E = $1875 (green area)
iv) tot. social surplus = ABD (note deadweight loss at market
allocation is G) = $ 4687.5 million.
v) The tot. tax revenue is equal to $25/barrel * 75 million
barells = $1875 million = E + C

d. Set the Quota at the SE quantity of Oil as illustrated below.
$/
barrel
Crude oil (millions
barrels /day
PMarket = 100

QMarket
= 90
$ Marginal
Private
Cost
$ Marginal
Social
Benefit
A
B C
190
40
0
0
190
65
$ Marginal
Private
Benefit
$ Marginal
Social Cost
PSE = 115
QSE =

75
D
E
F
H
Quota = 75
million
barrels/ day
G
I
J
90
e) The money socially efficient quota is applied at the socially
efficient level of output. The new
supply curve is the same as the old supply curve for quantities
lower than the quota after which it
becomes vertical at the quota (dashed crimson line). At the old
market price of $100/ barrel, the
demand is 90 million barrels while the supply is 75 million
barrels such that there is excess
demand. This drives the price up PSE = $100/thneed until the
demand equals new supply at QSE
= $ 100 mill barrels per day.

f)
i) $ Total Consumer Surplus
= $Total Willingness to Pay (Benefits) - $ Total Expenditure
(Costs)
= [A+B+C+D+E+F] – [B+C+D+E+F]
= A = (190 – 115) * 75/2 = $ 2812.5 million
The total consumer surplus in the unregulated market is (190 –
100)*90/2 = $4050
million/ year. Hence, consumer surplus has fallen.
ii) $ Total Producer Surplus
= $Total Revenue (Benefits) – $Total Producer Costs
= [B+C+D+E+F] – F = B+C+D+E
= [$115/thneed * 75 million thneeds] – [40*75 million thneeds
+ (90 – 40)*75/2]
= $ 8625 mill - $ 4825 = $ 3750 million/year.
This is less than the producer surplus under the unregulated
market ($ 90 * 90 mill/2 = $4050
million/ year). Hence, in our example, the total producers
surplus went down –however, it is
possible that it could rise because the price they receive rises
(which all else equal increases
revenue) while the amount sold falls (which all else equal
reduces revenue). In our example, the
latter effect dominates the former so our total producer surplus
fell.
iii) total external costs = C+E
iv) total social surplus = ABD
v) total quota rent = E+C (this is how much quotas would sell

for in a perfectly competitive
auction)
Under quota giveaway, the government collects no revenue. If
instead, we auctioned off the
quotas, and each quota sold for a price of 25$/bbl, the
government would collect a revenue equal to
area C+E = 25 $/barrel * 75 million barrels = $1875 million.
The total consumer surplus is the
same as under the quota give way while the producer surplus is
equal to area B+D = (115 – 65) *
75 million/2 = $1875 million.
We can see from the small numbers I am getting for total
producer surplus and so on that my
demand curve intercept is far too low (however, my x-axis is
based on the data). Also, the linear
curves were employed for heuristic purposes.
Also, the demand is by oil refineries and hence, the consumer
surplus is the surplus to the
refineries. There will be more surplus higher up the supply
chain.
2) Fixed external costs include GHGs produced when the
airplane was made and when the airport
was constructed. These do not vary with the number of flights.
Variable GHG costs is 1 tonne/flight* 200 $/tonne = $200. We
can see that this carbon tax will
provide some deterrent to flying.

3) Positive Externalities from forests
a) $ MBPrivate = $ MWTP = 10 – Q/2
$ MC = 10Q
To find market equilibrium, set MBPrivate = MCPrivate
10 – Q/2 = 10Q
10 = 10Q + Q/2 = 21Q/2
QMarket = 20/21= 0.9523 hectares
PMarket = 10 – 0.9523/2 = $9.5 mill/ hectare
∴ the unregulated competitive market will supply 0.9523
hectares at a price of $9.5 million
each (the price here represents the net present value over the
century).
b) MBExternal = PCO2 * CO2 sequestered / hectare = $
20,000/tonne * 2000 tonnes/hectare
= 40,000,000 $/hectare = 40 mill $/hectare
c) MBSocial = MBExternal+MBPrivate
= 40 + 10 – Q/2 = 50 – Q/2
Set equal to MCSocial to get the efficient quantity of thneeds.
We assumed no negative externalities, so MCSocial =
MCPrivate
MBSocial = MCSocial
50 – Q/2 = 10Q
QSE = 4.76 & PSE = $47.62 mill $/hectare
We can see that the market fails to provide enough of the forest
due to the private parties
being unable to capture the value of the externalities.
d) TBExternal = 4.76 hectares * 40 mill/hectare = $ 190.4
million.
e) See graph.
f) A quantity mechanism is a forest floor of 4.7 hectares while a
price mechanism is a

marginal subsidy of $40 mill/hectare. Alternatively, if we start
out with forest, we could
charge a $40 mill/hectare for cutting it down.
g) The quantity mechanism (floor on amount of forest) is more
likely to hit the target than
the price mechanism (subsidy to conserve forest) because the
government is unlikely to
have accurate demand and supply curve estimates and hence
will have trouble knowing
how private parties will react to the tax. Quality mechanisms
can also be employed. For
example, all logging must sustainable practice standards.
h) The marginal subsidy is going to be expensive to finance. If
the subsidy is relative to BAU
(here the market quantity), the government is may mis-estimate
this and end out paying too
much subsidy. An alternative is to use nature as the baseline
and to tax all alternative uses
by $40 million/ hectare_century. The forest would generate
revenue for the government
and this could be used to reduce taxes elsewhere and to finance
public goods.
4 a) A tax on buses only provides an incentive to reduce the
number of buses. This will lower
GHGs from buses but provides no incentive to develop low
GHG buses.
b) Since gasoline produces GHGs upon combustion and since a

tax on gasoline will provide
incentives to use less gasoline, this will provide an incentive for
firms to produce buses that use
less gasoline and potentially less GHGs. However, we also
better make sure that there is a tax on
liquefied coal because if the price of gasoline rises too much,
liquefied coal may be used and this
will also cause a lot of GHGs.
c) A tax that is levied on the actual emissions from each bus
would be difficult to implement
due to needing to put emissions monitors on every bus (or car).
Bus companies might tamper
with the monitors to save money on the tax increasing
government’s regulatory costs further.
Although directly targeting transport GHGs would however
provide incentives to reduce GHGs
and might also provide incentives to invent ways to capture
GHG emissions from transport
vehicles, making a target on GHGs ideal in theory, in practice,
scientists do not think that it is
likely that we will be able to capture and store emissions from
mobile sources such that the
expected benefits of directly targeting transport GHG emissions
are not expected to outweigh the
additional regulatory costs of CO2 monitoring.
The simplest policy on transport GHGs are levies on the final
transport fuel that are proportional
to the GHGs emitted when the gasoline is combusted. Taxes on
GHG emissions can also be
levied further up the supply chain at refining, transport, and
processing and extraction stages.
This will be an efficient way to tax gasoline and diesel as the
tax will be proportionate to the
GHG’s produced along the entire lifecycle. Transport fuels
from high GHG sources like Tar

Sands would be relatively expensive providing incentives to use
the least dirty transport fuel
during an oil phase-out.
5. An example of thneeds, which provide positive externalities
are natural ecosystems like
forests, wetlands and marine areas. A quantity mechanism to
achieve socially efficient amounts
of forests is a quantity floor (ex. National and Provincial Parks)
or a subsidy. Households, firms
and governments could be paid subsidies for the amount of
natural ecosystems they conserve.
Green subsidies can be financed by taxes on negative
externalities. Another example is replacing
high GHG energy source (ex coal) with wind turbines. The
positive externality from the wind
turbine equals the savings in external costs from not combusting
coal minus wind power GHGs.
Note that most of the externalities from wind are fixed external
costs incurred when manufacturing
the wind turbines as well as fixed costs on site such as roads to
access turbines, costs of
manufacturing computer equipment and so on.
L6: Correcting Market Failure
(c)Ruth Forsdyke
- Fossil fuel use for international trade was not accounted for
under the Kyoto Protocol. Raising the price of fossil fuels
would raise the price
of transportation helping to correct the externality.
- International trade agreements like the WTO and the NAFTA
fail to contain provisions to make users pay for their GHG and

other environmental
externalities. In absence of Pigouvian pricing of inputs to
production (like a tax on GHGs), it would be money efficient to
allow importers to
place tariffs on imports based on the GHGs that were created
during production of the good. This is difficult to do under
WTO rules. WTO rules
need changing. Currently, the EUʼs carbon tax on emissions on
air traffic is being challenged by China under WTO rules.
===============================================
====================
* Draft Copy_ not for widespread distributions as permissions
for copyrighted items not attained.
- no copyright claim on copyrighted or public domain media.
Copyrighted media used under Dalhousies Copyright Act.
Hence, this document is
not for public distribution.
Cover picture container ships released into public domain by
Ruth Forsdyke (please cite).
Topics List:
1.Introduction & basic policy types.
2.Backgrounder on Transport Emissions.
3. Regulating Markets with GHG Negative Externalities
3.1 Quotas
3.2 Taxes
3.3 Targets along supply chain
3.4 Quality Mechanisms
4. Comparing Price vs Quantity Mechanisms
5. Regulating Markets with GHG Positive externalities.
5.1-Backgrounder forest carbon sinks

5.2- Pigou’s model of Positive Externalities.
5.3- Regulating a market with Positive Externalities.
6. Removal of Inefficient Subsidies on Fossil Fuels
7. Equity
8. Summary
1-Introduction:
- Having just introduced the Alfred Pigou’s
externalities and monetary social efficiency
framework, the key framework employed in
environmental economics, and a necessary tool to
understanding global warming economics, we are now
ready to investigate policies to correct the
market failure.
Arthur Cecil Pigou
(1877 - 1959)
Recall that Pigou’s framework illustrates that if there
are negative externalities, a perfectly
competitive model market will maximize the total
private surplus of the market but not the total social
surplus; Prices will be too low because they do not
reflect full social costs while output will be too high.
Pigouvian policies work by getting private
parties to take into account their externalities by
making them pay the external costs or rewarding

them with the external benefits.
This is called “internalizing the externalities”.
- There are a variety of available policy tools .
- Economists categorize policies according to:
1) Whether they target prices, quantities,
or qualities of GHG impacting goods or
services.
2) What is the most direct target of the
policy.
The policy can most directly target:
i) intended outputs of production units, i.e.
“thneeds”, including goods, services and intermediate
goods at the various stages along the supply chain,
ii) residual byproducts (the GHGs)
iii) human attitudes, beliefs, norms, values via
information provision and moral suasion.
- Multiple policies can be employed simultaneously.
In this lecture, we will focus on policies, which most
directly target the thneeds markets.

- There are two types of production units to
consider. Those that cause atmospheric GHGs
to...
1) increase and hence cause negative
externalities (ex. transport in cars) or
2) decrease and hence cause positive
externalities (ex. natural forests or wetlands).
Firstly, since we have already developed the corresponding
Pigouvian framework, we’ll look at policies to correct
failure in markets that cause negative GHG externalities.
Our application will be gasoline.
Secondly, after introducing Pigou’s framework to examine
market failure due to positive externalities, we look at a
positive-externality-causing thneed, the service of
protecting natural forests, which remove carbon
dioxide from the atmosphere through photosynthesis and
store it in the carbon sinks (carbon sequestration).
Throughout, we’ll discuss pros and cons of policies
which target market prices, quantities or qualities vs. other
targets such as the GHGs themselves.
2-Brief Backgrounder on
Transport Emissions
Source image: Transport and Its Infrastructure (IPCC, 4th
Assessment Report) http://www.ipcc.ch/pdf/assessment-
report/ar4/wg3/ar4-wg3-

chapter5.pdf
To investigate policies to correct market
failure in the case of negative GHG externalities,
we will investigate the context of travel
emissions.
- for detailed discussion of the
Transportion services are an important source of
GHG emissions. In 2004, transport emissions made up
about 13% of world GHG emissions about 6.4
Gt.
θWTransport
= 0.13
EW2004 = 49 Gt Transport Share
= θWTransport * EW2004
= 0.13 *49 Gt
= 6.4 gigatonnes
The 2004, emissions from the transport
sector weighed about 50 times as much as
the human population.
To calculate world (W) emissions from the
transport sector, multiply world total emissions by
the transport share.

- Fastest growing share in Annex 1 countries and second in non-
Annex 1 countries.
6.4 Gt underestimates the total share of
emissions due to transport as many transport
emissions are accounted for in other sectors.
- energy to make
transport
vehicles, roads,
ports, airports
and railway tracks
and to provide
power for these
sectors.
6.4 Gt
- ex. GHG
byproducts of
growing crops
like corn and
palm oil to
make biofuels
and food to
power
cyclists,
pedestrians
and donkeys.
- Details are found in National GHG inventories and these
would allow us to make estimates of the amounts of the other
sectors that contribute
to the transport sector.

- The sectoral picture here is constructed from the GHG
inventory data available at:
Greenhouse Inventory Data:
http://unfccc.int/ghg_data/items/3800.php
- Under business as
usual (BAU), i.e. a lack of
regulation, transport
GHG emissions expected
to double globally by
2050.
- fastest growing sector in
Annex 1 countries and
second in non-Annex 1
countries.
As such, regulating transit
emissions is essential to
preventing a 20C
temperature rise.
Source image: Transport and Its Infrastructure (IPCC, 4th
Assessment Report) http://www.ipcc.ch/pdf/assessment-
report/ar4/wg3/ar4-wg3-
chapter5.pdf { also see pg. 162, DP for a brief summary}
- Shipping of crude oil and oil products made up 40% of the
demand for shipping services in 2005 (pg. 335)
- Canadaʼs transport sector (only including oil combustion not
making cars and so on) was responsible for 24% of GHGs
(considerably higher
than the world average)
- From 1990 to 2008, emissions from Canadian cars fell by
12%. While this looks good on the surface, it isnʼt because
emissions from “light

trucks” rose by 55%.
- Under the Corporate Average Fuel Efficiency Standards
(CAFE standards), car maker fleets had to achieve average fuel
efficiency standards
for new vehicles. Cars had a tighter standard than light trucks.
Car makers responded by marketing light trucks to consumers
instead of cars,
thereby successfully changing peopleʼs preferences. These
“light trucks” are the SUVs and minivans which were not
popular before the 1990s.
This is an example of a poorly designed policy.
- Another reason for North American automakers favouring
light trucks was due to a higher tariff rate on light trucks than
cars. The tariffs were
imposed on European automakers in retaliation for a European
tariff on frozen chickens.
- Emissions from domestic aviation, domestic marine, rail,
buses and motorcycles also rose.
International trade increased massively in the 1990s, for
example due to signing of free trade agreements (ex. WTO and
NAFTA). This also
increased transport emissions..
http://www.climatechange.gc.ca/default.asp?lang=En&n=97C0E
131-1
Under BAU, the stock of light duty vehicles
(i.e. cars and “light trucks”) is expected to triple by
2050.
- Light duty vehicles include cars, SUVs and minivans, i.e.
private passenger vehicles.
- According to the Stern Review (Annex 7c.), in the early
2000s, fuel efficiency in the USA was about 2/3 the level in the
EU. The EU has

significantly higher gasoline taxes providing people with
incentives to drive more fuel efficient cars. Crude oil is also
higher priced in the EU vs
American market (Brent Spar Price is $113/barrel vs. $
98/barrel in USA.
- the Keystone XL pipeline is being extended from Cushing to
Port Arthur Texas to export oil from US refineries. Without a
current increase in
production from Alberta Tar Sands to Cushing, we would expect
the US price of gasoline to rise. The State of Nebraska has
approved the
pipeline. There is great pressure for Obama to approve it.
However, American climate scientist has heavily advised
against this warning that in
order to prevent the > 2 degrees temperature rise, non-
conventional oil and gas must remain in the ground.
Source Image: Pg. 334 of 334, Transport and its Infrastructure
(IPCC)
http://www.ipcc.ch/pdf/assessment-report/ar4/wg3/ar4-wg3-
chapter5.pdf
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1000
people
year

USA
Canada
ChinaGhana
India
Germany
Russian Fed.
Brazil
Denmark
Japan
We can see that cars per capita varies greatly by country
with an upward trend globally with about 13% owning cars.
World
- Passenger cars refers to motor vehicles other than 2-wheelers,
intended for carriage of passengers and designed to seat no
more than 9
people (so this includes SUVs).
- Interestingly we get a massive increase in cars per capita in
the USA after the crash. One hypothesis as to the reason is
recessionary
spending. Another is that due to a steep increase in the price of
oil, people decided to buy a second more efficient car but have
not yet retired
their gas guzzlers. This might be an interesting 4th year
project.
- Although Germany has more cars per capita than Canada, they
are more fuel efficient.

Kaya Type Equation for Cars:
Total Emissions from cars
= Population * Cars/capita * Average
distance driven per car * Average
energy per unit distance * GHGs/
unit car energy
Some ways to reduce emissions from cars:
1) Make fewer cars by building efficient public transit systems
and efficient urban planning such as compact cities/ this will
also save people
time.
2) make engines more efficient.
3) change to less carbon intensive fuel.
4) reduce emissions from non-CO2 GHGs from vehicle exhaust
and climate controls.
5) reduce the birth rate.
6) roundabouts which keep traffic flowing/ ban drive throughs.
7) use existing cars less.
8) make them lighter.
9) working from home.
10) job sharing so people are not so rushed.
11) Regulate automobile advertising which targets self esteem.
Kaya Type Equation for Cars:
Total Emissions from cars
= Population * Cars/capita * Average

distance driven per car * Average
energy per unit distance * GHGs/
unit car energy
= 1,337,825,000.00 0.04381451535*
= 58,616,154 cars
PopulationChina2010 * Cars/capitaChina2010
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P
o
p
’n
(b
ill)
Cars/
1000
people
2003 - 2010: In China, cars per 1000 people increased
from 10 to 44. Due to the large and growing population, #
of cars rose from ~ 12 to 59 million between 2003 & 2010.
# of cars per 1000 people data source:
http://data.worldbank.org/indicator/IS.VEH.PCAR.P3
population of china data source:
http://search.worldbank.org/data?qterm=population&language=
EN
100 km
Calculating GHG footprints from driving:
- Suppose this car meets the CAFC fuel efficiency
standard = 6.8 L/ 100 km

- Carbon footprint (E) = 6.8 L * 3.0167 kg/L
= 20 kg CO2e
- External cost to drive 100 km = ?
- Assume PCO2e = $50/tonne
- To visualize 6.8 L of oil, imagine 6 litres of milk.
100 km
Calculating GHG footprints from driving:
- Suppose this car meets the CAFC fuel efficiency
standard = 6.8 L/ 100 km
- Carbon footprint (E) = 6.8 L * 3.0167 kg/L
= 20 kg CO2e
- External cost to drive 100 km = 20 kg
CO2e * 50 $/tonne CO2e * 1 tonne/ 1000 kg = $1
- Assume PCO2e = $50/tonne
- To visualize the equivalent weight of 20 kg of carbon dioxide,
note that 20 kg = 44 lbs-- so imagine the weight of 44 lbs of
butter. This is also
about 1/3rd of my weight.
- Since GHGs are invisible, we have a hard time taking them
seriously, visualizing them may help us to understand the
problem.

100 km
- Current gasoline price in Halifax = 125.1 cents/ L
(41.82 cents of this is tax including provincial,
federal excise taxes and GST/PST)
Current gasoline cost consumer to drive
100 km = 125.1 cents/ L* 6.8 L/100km = $ 8.51
If drivers had to pay for the GHG externality at the
low carbon price of $50/tonne, how much would it
cost them?
- For example, the Nova Scotia excise tax on gasoline is 15.5
cents/L with the national excise tax of 10 cents/L. The
GST/PST of 15% is then
applied on top of that.
- The tax breakdown is a sales tax of 16.32 cents/L and 25.5
cents/L of excise tax.
- Since drivers do not pay the full social cost of driving (i.e.
this tax is too low), they are subsidized. Subsidies are
inefficient.
- The subsidy is even worse for other types of fuel. For
example, Nova Scotiaʼs fuel taxes are:
15.5 cents/L gasoline.
15.4 cents/L diesel.
Propane = 7 cents/ L.
Marine fuel = 1.1 cents/L
Aviation fuel = 2.5 cents/L
Biofuels (which have higher GHG footprints than diesel when
sink damages are estimated) are subsidized in many places.
100 km

If we made this driver pay for the estimate of the
damages inflicted on others, which is referred to as
“internalizing the externality”, given our
(rather low) carbon price, it will cost this person
$1 more to drive a 100 km raising the price to
$9.51/km.
- As more people switch to public transit, there will be more
routes and the bus will stop more frequently reducing the
current inconvenience of
the bus in Halifax. Cars confer negative externalities on bus
riders by clogging up the road and reducing ridership of public
transit making it less
efficient.
- Bus riders confer positive user externalities both on other bus
riders (due to increasing demand which increases # and
frequency of routes)
and due to reducing traffic conjestion which helps both cars,
buses and cyclists move faster. Once public transit is efficient,
car riders have more
incentives to use it.
100 km
- On average, about 40% of the GHGs from driving are
produced when the car is made.
- Hence, as a rough estimate of the full LCA GHG
footprint, our car would produce 1.4 * 20 kg CO2 e/100 km
= 28 kg CO2e/100 km raising the external cost to 1.4 $/
100 km.
- The GHGs released when the car is driven are called
variable external costs (they vary with the output level,
here driving)

- The GHGs released when the car is produced are called
fixed external costs.
- The #s ignore sink damages
such as when Tar Sands oil is
mined in Canada or Venezuela or
when biofuels are used.
- If a person commuted 20 km per day to work and back, the
cost of commuting per week would only increase by $1 such
that this carbon tax
would not affect driving much.
- At a carbon price of $100/tonne, the number rises to $2.8
additional dollars per 100 km.
Say, you drive 10,000 km per year (about 200 km per week),
your yearly tax with a carbon price of $50/tonne CO2e would be
$140/ year. We
can see that this carbon tax is too low to have much of an
impact on driving for the typical Canadian.
A carbon tax of $500/year would increase this number of
$1400/year which would affect low and middle income people
who drive cars given that
the median Canadian income is $23,000 with a median Nova
Scotian income of $17,000 per year. However, the government
generates revenue
in an efficient manner and can reduce income taxes on these
groups.
- As more people switch to public transit, there will be more
routes and the bus will stop more frequently reducing the
current inconvenience of
the bus in Halifax. Cars confer negative externalities on bus
drivers by clogging up the road and reducing ridership of public

transit making it
less efficient.
Transport Policy
- fuel efficiency standards
- taxes or quotas on gasoline, diesel, aviation fuel or crude oil
(or all).
- measuring GHGs as they exit tailgate of transport vehicle
and taxing them as part of a general carbon tax policy.
- taxing cars when purchased.
- subsidizing public transit.
- good urban planning.
- subsidies to take inefficient vehicles off the road.
- policies to reduce birth rate.
- subsidies to low GHG fuel sources.
- subsidies to R&D on low GHG transport technologies.
- job sharing.
- moral suasion (provide information about global warming
crisis and encourage people to reduce transport footprints/
regulation of car ads may help.)
- Fuel efficiency standards are a good thing (if applied without
SUV/minivan loopholes) but on their own are insufficient. If
your car is more
efficient, it takes less energy to drive a km making the price of
driving cheaper. People may then decide to drive more because
it is cheaper.
This can actually cause GHGs to increase. This is an example
of Jevonʼs Paradox by the 19th century economist Stanley
Jevons.
3-Pigouvian Policies to

regulate markets with
Negative Externalities
Now, we will use our Pigouvian framework to
investigate policies which directly target markets
which produce goods, services or inputs including
fossil fuels.
We will assume that the thneed is gasoline.
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
Qm = 40
Pm = 60
$M
C
Pr
iva

te
= 2
0 +
Q
$ MB Private
= 100 - Q=
$ MB Social
$ MCExternal
= $50 / thneed
$M
C
So
cia
l
= 7
0 +
Q
Recall our market failure.
QSE = 15
PSE =
85

- Make sure you understand the graph before moving on.
Identify the
deadweight loss of the market.
Money Socially efficient allocation = Policy Goal
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
Qm = 40
Pm = 60
$M
C
Pr
iva
te
$ MB Private
= $ MB Social

$M
C
So
cia
l
QSE
PSE
Privately
efficient
allocation
DWL
= Max TSS
- The perfectly competitive market produces 40 thneeds at a
price of $60/ thneed. This results in a loss of total social
surplus (relative to the maximum) of the area labelled DWL
(deadweight loss).
- The money socially efficient allocation maximizes the total
social surplus (pink triangle) at the socially efficient price of
$85/tonne and quantity of 15 thneeds/ period.
- To “correct the market” regulations will “internalize the
externalities” meaning that they fall on private parties
changing their incentives such that the regulated market will
operate at the socially efficient allocation.
- The essence of the environmental economics approach is to
align private costs and benefits with social costs and
benefits.
- We saw in the car example that charging people $50/tonne
CO2e will not make much of a difference on Canadian

driving habits. However, it may help to get people used to the
idea and it will provide government revenue allowing
reductions in inefficient taxes like income taxes and corporate
taxes.
31
There are three basic types of policies
which directly target externalities in a
market. These are:
1) Price mechanisms (ex. taxes on output of goods with
negative externalities like transport and subsidies to goods with
positive
externalities like forests and wetlands)
2) Quantity mechanisms (ex. quotas on output of goods with
negative externalities and floors on goods with positive
externalities such as
forests and wetlands.
3) Quality mechanisms (ex. quotas on output of damaging
varieties of goods such as electricity produced using inefficient
coal fired
generators or a minimum on the amount of electricity produced
using renewable
energy such as renewable energy quotas). Performance
standards (ex. fuel
efficiency standards), Technology Standards, and Design
standards (like urban
planning rules) are examples.
Next, we look at these 3 policy types for goods
which produce negative externalities using
gasoline as our example.

What quota would you impose on the
good, service or input to achieve Social
efficiency?
3.1_Quotas
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
Qm = 40
Pm = 60
$M
C
Pr
iva

te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
Privately
efficient
allocation
- The quota can be illustrated as a vertical line at the socially
efficient
point.
- The quotas will need to be distributed among firms (for
example, by
permit giveaway or by auction).
- A problem with this can be political corruption whereby
politicians
accept bribes from firms to secure quotas.
- Bribes may be indirect (ex. election campaign finance)
- Ways to enforce quotas include fines and jail sentences.
- Firms with deeper pockets to hire expensive lawyers may
challenge
government in court, increasing regulatory costs.

34
What does the new supply
curve look like with the Quota?
- Go back to last slide, think about the question and try to draw
the new supply curve before moving on.
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
Qm = 40
Pm = 60
$M
C
Pr

iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
Old Supply
New Supply
Demand
Immediately after
quota is applied,
price is $60/ thneed.
Is there excess
demand or excess
supply?
35
- The new supply curve is the same as the old supply curve
below the

quota. If P< 35, the inverse supply is: P (Q) = 20 + Q
- If P = $ 35/ thneed, firms will supply 15.
- If the price exceeds $ 35/ thneed, they will still supply 15
because they
will be fined otherwise. Hence, the supply curve is a vertical
straight
line for P>=15 (i.e. above the quota)
- The crimson dots represent the new supply curve.
36
What happens to the market price
after the Quota is Imposed?
Hint: Look back at the previous slide and notice
that immediately after the quota is imposed, the
price will be the old market equilibrium price of
$60/ thneed.
Is there excess demand or excess supply at
the old equilibrium price?
37
Right after quota is imposed, BEFORE price has adjusted, the
price is Pm = 60 $/ thneed (the old equilibrium price) ....
Demand (60) = 40 thneeds/ year
New Supply (60) = 0 thneeds/ year
Demand (60) > New Supply (60)

==> Excess Demand
Prices are driven up. Prices stop rising at PSE = $85/ thneed
at which point, Demand (85) = New Supply (85)
This is the regulated market equilibrium. Note that the
regulator targeted the quantity but the market did the work
raising the prices. Hence, the quota is called a “quantity
mechanism”.
The Invisible Hand Adjusts the Price:
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
Qm = 40
Pm = 60
$M
C

Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
Demand (60) = 40
Supply (60) = 15
Demand > Supply
∴ excess demand
Prices rise until
Demand = Supply
- “Shift” Supply
- Move along Demand
Excess

Demand
- Note, the supply curve “shifts” and then we move along the
demand
curve --i.e. as the price rises, people reduce their demand.
- If the quota is set correctly, social efficiency is attained.
- We note that the price increase rations the goods to the people
with
the highest willingness to pay and so we can see how Pigouvian
Policy
can potentially harm low income people. However, the money
income is
highly correlated with GHG footprints.
- If quotas are given away (not auctioned), government will
collect no
revenue to compensate low income people for price increases.
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
Qm = 40

Pm = 60
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
Under Quota, the
quantity falls and
the price rises until
the new demand
=the new supply at
the SE allocation
such that TSS is
maximized.

40
Now lets look at the effect of the policy on
the social welfare of the private parties,
third parties and government.
The government can either give away
quotas or auction them or a combination
of these two approaches. If quotas are
given away, the government receives no
revenue. In the next example, we will
assume that the quotas are given away.
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva

te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
How does Quota
affect
consumers?
A
B
C
D
E
F
Find total consumer
surplus under market
allocation, under
quota and the change.

G
H
I
Pm = 60
Qm = 40
- Try this on paper and then check your answer on the next
slides. Use
letters to indicate the areas.
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr

iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
G
H
I
Total

Consumer
Surplus (QM)
= A+B+C+D
Qm = 40
Pm = 60
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social

$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
G
H
I
Total
Consumer
Surplus
(QSE) = APm = 60
Qm = 40

Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE

= 15
PSE = 85 A
B
C
D
E
F
∆ Total
Consumer
Surplus
= - (B+C+G)
G
H
I
Pm = 60
Qm = 40
Quota
Quantity of
Thneeds/ period
$ / thneed

20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
How does Quota
affect
producers?

A
B
C
D
E
F
Find total producer
allocation, under
G
H
I
Pm = 60
Qm = 40
slides. Use
Quota
Quantity of
Thneeds/ period

$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B

C
D
E
F
Total
Producer
Surplus(Qm)
= D+ HG
H
I
Pm = 60
Qm = 40
Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0

100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F

G
H
I
Total
Producer
Surplus(QSE)
= B + C + D
Pm = 60
Qm = 40
- Now the total revenue is B+C+D+E and the total producer
costs is only E (they sell less
goods).
- Selling fewer goods will DECREASE producers total revenue
but each good sells
for a HIGHER price and this effect will INCREASE their
revenue. If the latter effect
dominates, then the total producer surplus could increase (as
when a monopoly restricts
output to drive up the price thereby increasing their profits).
- Hence, the effect on the total producer surplus is ambiguous
depending on the size of
the quota.
- Note that many firms are not competitive. For example, Nova
Scotia Power is a
regulated monopoly in electricity transmission and has a near
monopoly in generation
and is subject to price ceilings.

= 15
PSE = 85 A
B
C
D
E
F
G
H
I
∆ Total Producer
Surplus(QSE)
= (B + C + D) -
(D+H)
= B+C - H
Pm = 60
Qm = 40
If H > B+ C
If H < B+ C

Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15

PSE = 85
If, instead of being
given away, quotas
are instead
auctioned off in a
perfectly competitive
market...
A
B
C
D
E
F
Total
Producer
Surplus= B
G
H
I
Pm = 60
Qm = 40
- Firms are going to like quota give away but will not like it if

quotas
are auctioned. An example of a situation in which quotas are
auctioned
is fish permits. In practice, large trawling companies have
purchased
quotas or rent them from individual fishers to whom they were
given.
50
What about the change in welfare of the 3rd Parties
due to the quota policy? (the people and animals
who experience the damages from byproducts like the
GHGs and biodiversity losses).
- To find the total change in surplus to the third parties, we will
need to
find the area representing the total external costs under the
quota
policy and subtract it from the area representing the total
external costs
under the market policy.
- Try this and then check your answer on the upcoming slides.
Quota
Quantity of
Thneeds/ period
$ / thneed
20

0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D

E
F Total External
Costs (Qm)
= C + D + F + G
+ H
G
H
I
70
Pm = 60
Qm = 40
- Note that the total external costs at the market allocation is the
area under the
marginal external cost curve from 0 to 40. However, since we
have removed
the marginal external cost curve we will illustrate this area
another way.
- Since total social costs is equal to the area under the marginal
social cost
curve and the total private costs are the area under the marginal
private cost
curve, the area between the marginal social cost curve and the
marginal external
cost curve must equal the total external costs.
- Recall that marginal external costs are $50/ thneed, so total
external costs at
market quantity are equal to $50/thneed * 40 thneeds = $2000.

Quota
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l

QSE
= 15
PSE = 85 A
B
C
D
E
F
G
H
I
70
Pm = 60
Qm = 40
Total External
Costs (Qm)
= C + D
- Now the external costs are much smaller as there are fewer
thneeds
and hence fewer GHGs.

PSE = 85 A
B
C
D
E
F
G
H
I
70
Pm = 60
Qm = 40
∆Total External
Costs
= (C + D) - (C +
D + F + G + H)
= - (F + G + H)
The total external costs fell by area H + G + H making the third
parties
better off which was the point of the policy.

54
OR
∆ Total Consumer
Surplus
= B+C - H
∆ Total Producer
Surplus(QSE)
= - (B+C+G)
- ∆Total
External Costs
= (F+G+H)
∆ Total Social
Surplus = + F
- Based in changes in their respective total money surpluses,
consumers are worse off, producers may be either better or
worse
off, third parties are better off, and society as a whole is better
off
(the total money social surplus went up by the area equal to the
deadweight loss).
- Recall that F is the total deadweight loss!
- I have assumed quotas were given away here. If they were
auctioned, producers are also worse off but government will
gain a
revenue from selling the quotas. Identify the government
revenue
under quota auction as an area before moving to the next slide.

QSE
= 15
PSE = 85
How does Quota
affect each group?
A
B
C
D
E
F
Government Revenue
(if auctioned) = $50/
quota * 15 quotas =
$750
G
H
I
70
Pm = 60
Qm = 40

- This assumes that the auction is perfectly competitive in
which
case the firmʼs are willing to pay $50 per quota which is their
marginal
profit from the quota.
- If the quota market is not competitive due to few firms and
possibly
corrupt practices like bribes to government officials and bid
rigging
(where firms meet before and collude to agree to make low
bids), the
government would get less than the area C+D with the firms
getting
the portion that the government does not get.
Summary Quota Model
- the regulator sets the market quota equal to the
SE quantity and passes a bill of law making it illegal
for firms to supply more than this amount.
- there is excess demand at the unregulated price
and so the price rises to the $ SE price. The
regulated market is now in equilibrium at the $ SE
allocation.
- the externality is internalized. The users pay the
full social costs. The total private surplus and
total consumer surplus falls while the total
producer surplus may rise or fall.
- the total social surplus is maximized such that
the regulated market is said to be monetarily
socially efficient. 56

- Efficient quota alloction may not occur due to rent
seeking activities like bribes (such as election
campaign finance) and bid rigging.
- if relationship between thneed output (ex coal or crude
oil) and GHGs is known, quota can be a quick way to
hit the target GHG reduction with fewer possibilities of
cheating via loopholes. For example, James Hansen
recommends regulating rate of fossil fuel extraction.
- firms will prefer quotas to taxes because they get to
pollute for free. This leaves them with more has a merit
of giving them money to finance green technology
invention and adoption conditional upon government
imposing incentives for them to do so.
57
- politics should not inhibit our ability to think clearly about “in
principle options”.
- bid rigging is illegal under Competition Law.
- an example of a firm getting contracts without a proper
process is Halliburtonʼs war reconstruction contracts in Iraq.
The ex CEO of
Halliburton was Dick Cheney who at the time of the contract
allocation was the Vice President of the USA. He also served to
profit from this
due to holding stock options. This is an example of the
common phenomenon of a “revolving door”. Halliburton was a
key player in the also
BP Deepwater Horizon Oil Spill in the Gulf of Mexico due to
using substandard cement practice. This was the biggest oil
spill of all time (42
times bigger than the Exxon Valdez oil spill). Oil spills are
another massive externality from transport.

- quotas may lead to inefficiency if quotas are not
tradable because firms may be unable to adjust their
scale to an efficient level. Ex. in an extreme case, if all
firms get equal number of quotas which are not
tradable and the industry shrinks such that each firm
has too small a scale to be profitable, it would be
efficient to allow some firms to leave the market.
- On the other hand, environmental regulations may
make efficient scale smaller (ex. due to higher transport
costs) in which case, lack of tradable quotas would not
allow firm size to shrink.
58
- For example, suppose we had 10 firms in the market. Under
the market allocation, each firm
would produce 4 thneeds. Under the regulation, each firm
would produce 1.5 thneeds. The firms
may be unable to cover their fixed costs of production and all of
them would need to leave the
market. On the other hand, if 7 firms leave the market, the 3
remaining firms would produce 5
thneeds each enabling them to cover their fixed costs. With
only three firms, the market is
unlikely to be competitive and so we would need to use a
different model.
- Recall first year model of perfect competition in which firm
scale is found at point were U shaped
MC intersects minimum of U-shaped average cost curve (with 0
profits but positive variable
profits--i.e. producer surplus).

59
3.2_ Pigouvian Taxes
on Outputs of
Production Units
The second class of policies are price mechanisms
which means the price is the direct target.
Pigouvian taxes are directly levied on goods with
negative GHG externalities raising their relative price,
thereby providing incentives to substitute out of the
good entirely or into low GHG versions.
Source: International Energy Agency
G
e
rm
a
n
y
U
.K
.
F
ra
n

ce
Ja
p
a
n
C
a
n
a
d
a
U
S
AAvg Tax
$/ Litre
March
2008
1.36 1.32 1.27
0.60
0.31
0.11
- In which of the countries in the graph would you expect
people to drive more efficient cars?
Answer EU
- The main reason is higher gasoline taxes which provide people

with incentives to either not drive, to drive less or to drive more
fuel efficient
cars (Resources for the Future). If you go to Europe, you will
notice cars are smaller.
- Fuel efficiency standards are tighter in Europe also while
crude oil also has a higher price (http://www.bloomberg.com/
energy/)
Fuel Tax Graph: International Energy Agency
- A Pigouvian tax targets price directly and
then quantities adjust via the “invisible hand
mechanism.
- Consider a constant marginal tax (T = $50/
thneed) equal to the MCExternal of producers.
- The producers’ $MCPrivate (inverse supply)
shifts up by T to $MCPrivate_New (social inverse
supply) so they internalize the externality--see
green dashed line.
$MCPrivate_New = $MCPrivate_Old + T
= 20 + Q + T
= 70 + Q
Quantity of
Thneeds/ period
$ / thneed
20

0
0
100
$M
C
Pr
iva
te
= 2
0 +
Q
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
70

Pm = 60
Qm = 40
$M
C
Pr
iva
te (n
ew
)
= 2
0 +
Q
+
T
The marginal tax is
equal to the marginal
external cost at the SE
output level (which is
$50/ thneed).
The MCPrivate rises by the
marginal tax (green
arrow) causing the
inverse supply curve to
shift up by $50/ thneed
(green dashed).
- In our example, in which the marginal external costs are

constant such
that the marginal external cost is a horizontal line. If it were
not
horizontal, the new supply curve will not overlap the marginal
social cost
curve (as here), but will still intersect it at the socially efficient
allocation.
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15

PSE = 85
70
Pm = 60
Qm = 40
$M
C
Pr
iva
te (n
ew
)
We can think of the
new marginal private
cost as the “social
supply curve”, the
supply curve that would
exist if the producers
had to pay the full
monetary social costs
of the externality.
$M
C
Pr
iva
te (o
ld

)
Question: Right after the tax is imposed, the price of thneeds is
$60/tonne. Use
the concepts of excess demand or excess supply to explain what
happens to
the price and quantity of thneeds as the market adjusts to the
regulation.
Answer: Start in unregulated market with Pm = $60/thneed and
Qm = 40 thneeds.
Now add the tax causing the supply curve to shift upward to the
left. At the price
of $60/ thneed, the demand is 40 thneeds while the supply is 0
thneeds. Hence,
demand exceeds supply. The firms will discover they can
increase prices. As
they increase prices, demand will fall (movement along demand
curve).
64
Now lets look at the effect of the Pigouvian
tax policy on the social welfare of the
private parties, third parties and
government.
Source Picture Parliament Buildings of Canada:
http://en.wikipedia.org/wiki/Parliament_of_Canada
Quantity of
Thneeds/ period

$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85
How does Tax

affect
consumers?
A
B
C
D
E
F Find total consumer
allocation, under
G
H
I
Pm = 60
Qm = 40
$M
C
Pr
iva
te (
ne
w)

slides. Use
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So

cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
G
H
I
Total
Consumer
Surplus (QM)
= A+B+C+D
Qm = 40
Pm = 60
$M
C
Pr

iva
te (
ne
w)
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So

cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
G
H
I
Total
Consumer
Surplus
(QSE) = A
Pm = 60
Qm = 40
$M
C
Pr

iva
te (
ne
w)
- The socially efficient allocation is where the marginal cost
social curve intersects the marginal social
benefit curve (as long as its socially efficient to produce any
thneeds at all which wouldnʼt be the case if the MC
social curve intersects the y-axis above 100 in our case).
- Suppose the Factory is producing a quantity (Q) on x axis that
is less than Qse), we see that the marginal
social benefit exceeds the marginal social cost. For Q < Qse,t
is socially efficient to produce an additional
Qth unit as the society will gain more social benefits than it
costs them so the marginal social surplus must be
positive.
- If, on the other hand, at a given Q, the marginal social benefit
is lower than the marginal social cost, as is
the case when Q < Qse, then it will increase the total social
surplus if you decrease output by one unit since
you will forgo fewer social benefits than social costs saved.
Social “when to stop rule”: MBsocial = MCsocial (if Qse > 0).
Quantity of
Thneeds/ period
$ / thneed
20
0

0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E

F
∆ Total
Consumer
Surplus
= - (B+C+G)
G
H
I
Pm = 60
Qm = 40
$M
C
Pr
iva
te (
ne
w)
- The socially efficient allocation is where the marginal cost
social curve intersects the marginal social
benefit curve (as long as its socially efficient to produce any
thneeds at all which wouldnʼt be the case if the MC
social curve intersects the y-axis above 100 in our case).
- Suppose the Factory is producing a quantity (Q) on x axis that
is less than Qse), we see that the marginal
social benefit exceeds the marginal social cost. For Q < Qse,t
is socially efficient to produce an additional

Qth unit as the society will gain more social benefits than it
costs them so the marginal social surplus must be
positive.
- If, on the other hand, at a given Q, the marginal social benefit
is lower than the marginal social cost, as is
the case when Q < Qse, then it will increase the total social
surplus if you decrease output by one unit since
you will forgo fewer social benefits than social costs saved.
Social “when to stop rule”: MBsocial = MCsocial (if Qse > 0).
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social

$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
Find total
producer
surplus under
market
allocation, tax
regulation, and
the change.
G
H
I

Pm = 60
Qm = 40
$M
C
Pr
iva
te (
ne
w)
slides. Use
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C

Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
Total
Producer
Surplus(Qm)
= D+ HG

H
I
Pm = 60
Qm = 40
$M
C
Pr
iva
te (
ne
w)
- Recall this is the total revenue (D+ H + E + I) - total producer
costs (E
+I)
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100

$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
G

H
I
Total
Producer
Surplus(QSE)
= B
Pm = 60
Qm = 40
$M
C
Pr
iva
te (
ne
w)
- Now the total revenue is B+C+D+E and the total producer
costs is only E (they sell less
goods).
- Selling fewer goods will DECREASE their total revenue but
each good sells for a
HIGHER price and this effect will INCREASE their revenue. If
the latter effect
dominates, then the total producer surplus could increase (as
when a monopoly restricts
output to drive up the price thereby increasing their profits).
- Hence, the effect on the total producer surplus is ambiguous
depending on the size of

the quota.
- Note that many firms are not competitive. For example, Nova
Scotia Power is a
regulated monopoly in electricity transmission and has a near
monopoly in generation
and is subject to price ceilings.
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C

So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
G
H
I
∆ Total Producer
Surplus(QSE)
= (B) - (D+H)
Pm = 60
Qm = 40
$M
C

Pr
iva
te (
ne
w)
- Note that this is the same welfare result as would occur under
quotas if they are auctioned off in a perfectly competitive
market.
- We can see here that firms are going to tend to prefer quota
give-
aways to Pigouvian taxes. We will expect strenuous lobbying
by
firms to prevent Pigouvian taxes being put into place and we do.
Usually, they firms are reported in the paper as saying that jobs
will be
lost. Firms may also threaten to leave the country to operate in
a
country with lower pollution regulations. This is called a
“pollution
haven” effect.
73
What about the change in welfare of the 3rd Parties
due to the quota policy? (the people and animals
who experience the damages from byproducts like the
GHGs and damages to the natural ecosystems).
- To find the total change in surplus to the third parties, we will
need to
find the area representing the total external costs under the

quota
policy and subtract it from the area representing the total
external costs
under the market policy.
- Try this and then check your answer on the upcoming slides.
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So

cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F
G
H
I
70
Pm = 60
Qm = 40
∆Total External
Costs
= (C + D) - (C +
D + F + G + H)
= - (F + G + H)

$M
C
Pr
iva
te (
ne
w) The third parties gain
due to the reduction in
the total external costs
(identical result as with
tax)
The total external costs fell by area H + G + H making the third
parties
better off which was the point of the policy.
Question: How much tax revenue will the government collect?
Show
using areas on graph.
Quantity of
Thneeds/ period
$ / thneed
20
0
0

100
$M
C
Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
= 15
PSE = 85 A
B
C
D
E
F Government
Tax Revenue
= C+ D

= $50/ thneed *
15 thneeds
= $750/ period.
G
H
I
70
Pm = 60
Qm = 40
$M
C
Pr
iva
te (
ne
w)
- Note that if the MCExternal is not horizontal as in our
example, the green
new supply curve will not overlay the MCsocial curve and it
may be the case
that the total tax is greater than the total external costs. In this
case, lump
sum rebates can be provided or the tax may only be applied
above a
particular output level. The problem here is that is would be
administratively complex to apply a tax rate that increases with

output
levels.
- Since MCExternal are constant over short run for GHGs due to
these being
cumulative pollutants, we do not have to worry about this
problem for
global warming regulations.
76
OR
∆ Total Consumer
Surplus
= B - (D+H)
∆ Total Producer
Surplus(QSE)
= - (B+C+G)
- ∆Total
External Costs
= (F+G+H)
∆ Total Social
Surplus
= + F
∆ Total Tax
Revenue = C+D

- Based in changes in their respective total money surpluses,
consumers are worse off, producers are worse off, third parties
are
better off, and society as a whole is better off (the total money
social surplus went up by the area equal to the deadweight loss).
- Recall that F is the total deadweight loss!
77
3.3 Targets along Supply
Chain
78
75(5) 7(7) 90 (45) 385 (385)
Extraction
Initial
Processing RefiningTransport Transport
Combustion
Final
Product
10.32 L
125.5 ¢/L
Pigouvian Taxes are ideally levied along the supply chain
at the stages where the emissions are produced. This
provides the most direct incentive to reduce the emissions
at the point of creation. We can see here that the Tar (Oil)
Sands CSS Bitumen creates the same amount of

emissions as conventional oil (West Texas Intermediate)
when combusted (385 kg CO2e/ bbl gasoline) but creates
far more emissions in total (560 vs 450)
3(3)
Source: IHS CERA:
http://www.api.org/aboutoilgas/oilsands/upload/CERA_Oil_San
ds_GHGs_US_Oil_Supply.pdf
- This source is based on a Life Cycle Analysis commissioned
by the oil industry. It does not include GHG emissions due to
damage to the
carbon sinks or due to pipeline construction. The CSS bitumen
is the dirtiest oil source based on the analysis because the
process of steam
injection is very energy intensive. The mining is slightly less
energy intensive but results in destruction of boreal forests and
wetlands such that
overall, it may have the higher GHG footprint.
- The CSS bitumen mining could have its footprint lowered by
switching to lower GHG energy sources such as wind power,
solar power or
nuclear power.
- That said, even for the CSS bitumen, 64% of the emissions are
produced during combustion for a total of 360 bbl refined
product (ex. gasoline
or diesel).
Crude Production
Crude Transport
Distribution
Crude Refining

tonnes CO2e/
barrel refined
crude
0.1
0.2
West
Texas
Int.
CSS
Bitumen
- If we only levy the tax on the
final product (ex gas tax at
pump), the Tar (Oil) sands
gasoline would be priced the
same as the West Texas
Intermediate providing no
private incentives to
substitute into the lower GHG
oil or for the Tar Sands
producers to find lower GHG
ways to make the oil if cost
effective.
- Other than GHG emissions differences in the two basic
extraction processes, strip mining and In Situ, the 7 categories
of Tar Sandʼs crude
differ according to the liquids in which they are diluted. Since
bitumen is a tar like substance, it cannot be piped along lines or
refined in
conventional refineries until it is diluted to make it into a liquid

form. The bitumen can be diluted in light oils and also in
condensed natural
gas. The GHG intensity of the diluting fossil fuel will hence
also affect the GHG intensity of the crude oil.
- Mining and in situ will also differ with respect to their impact
on carbon sinks, biodiversity loss and other local water and air
pollutants.
Source Data = IHS CERA:
http://www.api.org/aboutoilgas/oilsands/upload/
CERA_Oil_Sands_GHGs_US_Oil_Supply.pdf
If taxes are applied based on GHGs at each stage, the
CSS bitumen gasoline costs 24% more.
$50/tonne * 0.175
tonnes/barrel
= $8.75/barrel
upstream tax
$50/tonne * 0.06
tonnes/barrel
= $3/barrel
CSS
Bitumen
West
Tex. Int.
pump tax
$50/tonne * 0.385
tonnes/barrel
= $ 19.25/

barrel
full life-
cycle tax
$ 28/barrel
$ 22.25/
barrel
$ 19.25/
barrel
10.32 L
- We can see that the CSS bitumen is much more GHG intensive
during the extraction - processing- transport and refining stages
than the
cleanest crude oil (almost 3 times the GHG emissions) while
both oils produce about the same amount of GHG emissions
during combustion.
Along the whole life cycle, the CSS bitumen produces about
27% more GHGs than the cleanest crude.
- Note: The 7 Tar Sands crude oil categories are one out of two
basic categories 1) Strip mined and 2) In Situ (with two
categories Steam
Assisted Gravity Drainage (SAGD) and Cyclic Steam
Generation (CSS). Under strip mining, the boreal forests and
Earth crust from above the
oil is removed. Under In Situ methods, the tar sands are too
deep to be strip mined. Because the bitumen is highly viscose,
it can only be
removed by heating it up to make it flow. Steam is injected
down the drill and the bitumen becomes viscous enough to force
it out. Ignoring the
GHG emissions due to sink destruction and pipeline

construction, the In Situ process uses 15% more energy over the
entire life cycle than
the average US crude while the mining uses 5% more energy.
- these taxes are on the refined final product (ex. gasoline).
Blunt Tax
= $50/tonne CO2e * .
0.480 tonne CO2e/ barrel
= $24/barrel
Correct Tax CSS
Bitumen
= $50/tonne CO2e *
0.560 tonne CO2e/ barrel
= $28/barrel
Ex. Apply full Pigouvian tax on average
GHG final product (gasoline pump)
Production
GHGs
Combustion
GHGs
West Tex Intermediate
US Av’g Dom. Crude
Mining Dilbit
Mining Bitumen

SAGD Dilbit
Mining SCO
SAGD Bitumen
SAGD SCO
CSS Bitumen
0 .4 .6.2
GHGs (tonnes CO2e)
T
a
r
S
a
n
d
s
C
a
n
.
- All estimates based on IHS CERA report (see figure three)
Houston

Keystone
(built)
Keystone XL
(proposed)
Port Arthur
Cushing
Steel City
Hardisty
Northern
Gateway
(proposed)
Trans Canada
Enbridge
Exports
Oil Sands
- Note that Enbridge has many other pipelines (ex. from Tar
Sands to Chicago linking up to Montreal (where there are
refineries) and running
down to Cushing, a big pipeline hub (not shown).
- An Environmental impact assessment of the Northern Gateway
Pipeline is currently underway. Concerns are oil spills off BCs
coast which
would ship diluted bitumen in tankers to places like China and
California for refining.

- The Cushing to Port Arthur Stage of Keystone XL Pipeline has
already been approved. If the top part is not allowed to go
ahead, we would
expect higher oil prices in the USA because some of the oil will
be exported. This might increase pressure for the top portion to
be built to allow
for more Canadian crude exports.
- Oil shocks have macroeconomic impacts.
83
3.4_Quality Mechanisms
Source Photo: Alfred Cecil Pigou: New School Website
84
Other means to directly regulate markets include
technology, design, and performance standards.
An example of performance standards is are fuel
efficiency standards (CAFE) which specify that the
fleet of new cars must meet a minimum fuel efficiency.
These do not guarantee GHG caps will be met due to
reducing the price of driving a mile such that people
may increase their driving which can include decisions
to build homes further from work (Jevon’s Paradox).
85

Renewable energy quotas specify that a minimum
amount of energy will be made by renewable
energy. For example, there are minimum quotas on
biofuels and for electricity, many places including
Nova Scotia have renewable energy targets.
Studies have found that ethanol biofuels produced
from corn create more GHGs than diesel such that
this policy was poorly designed. If instead, full Life
Cycle Analysis had been conducted and taxes
levied on GHG produced by each type of fuel, these
high GHG biofuels policies would not have been put
into place.
Searchinger, T. et al (2008) Use of U.S. Croplands for Biofuels
Increases Greenhouse Gases Through Emissions from Land Use
Change, Science, 319, 1938.
86
Technology, design and performance standards can work
faster than markets due to human brains being
substituted for markets.
For a trivial ex., this unnecessary plastic laundry scoop
could be banned as a wasteful technology without any
LCA as it is a “no brainer” wasteful product.
They may also allow early deployment of technologies
which are currently expensive but are expected to
become cheaper over time (ex. solar power).
The big drawback is flexibility in contrast to general
policies like carbon taxes which leave firms with freedom

to choose cheapest abatement technology, thereby
making use of decentralized force of invisible hand.
87
4_ Comparing Price vs.
Quantity mechanisms
88
1) Pigou taxes generates revenue while quota (if given
away) does not. Uses include:
- tax shifting reduce other taxes helping to compensate
consumers for the price rise (ex. income taxes + lump sum
rebates particularly on low & middle income groups).
- finance green climate fund, part of the Copenhagen
mechanism to provide lower income countries with GHG
mitigation and adaptation capacity.
- corporate tax reductions reducing probability of
movement to low tax zones called pollution havens.
- subsidize subsidize renewable energy adoption and
research and development (R&D) by government &
universities, or paid as grants to firms.
-The BC carbon tax is revenue neutral meaning that taxes were
removed elsewhere (income and corporate) so
government revenue did not change. Many of the tax decreases
were on corporations. Lump sum rebates given to
households.
- It is important to note that even though one might think that
the low income people will merely go and buy the same

products thereby undoing the policy, they will still find that the
GHG intensive thneeds are relatively expensive in
comparison to green alternatives. For example, the bus will be
relatively cheap in comparison to the car due to fewer
GHG emissions per passenger mile while the CSS Bitumen
gasoline will be relatively expensive in comparison to
the Texas Intermediate.
- Taxes on externalities are monetarily socially efficient (as
illustrated above). To contrast, taxes such as income tax
reduce total social surplus (in money). Hence, taxes on
externalities allow us to replace inefficient taxes with efficient
ones.
89
MCExternal
Quota
hits target
Thneeds/
year
$ / thneed
2) Hitting the target: If the government does not estimate
demand and supply curves accurately (which is likely due to
difficultly of getting estimates of firm’s costs), quotas (if
enforced) guarantee output is capped whereas with a tax,
output may not fall as much as the government wants such that
total external costs are higher than wanted. This is particularly
problematic if the marginal external cost curve is increasing
rapidly above the desired cap.

- Similarly, a strict floor on forest size and quality guarantees a
minimum amount while subsidies to get private parties to
conserve forests donʼt
guarantee that we will save the minimum.
4) Tax enables firm scale to adjust flexibly to the
policy in contrast to quotas. For example, if the
industry gets smaller, some firms may need to leave
the industry. On the other hand, if efficient scale gets
smaller with environmentally friendly technologies,
firms may want to enter industry. Tradable quotas can
work similar to taxes in this respect although they may
also enable big firms to hoard quotas to prevent
market entry reducing competition.
3) quotas are highly subject to political lobby which
can lead to corruption. Ex. firm Y donates money to
campaign of politician X.
5) quotas may be rapidly applied to reduce or ban
obviously wasteful practices or technologies. For
example, plastic laundry scoops bundled with powder
laundry detergent, or bottom trawling (which damages
ocean bottoms) could rapidly be banned. The same
holds for tech, design and performance standards.
6) quotas with rations may be a very fair policy and
this is why we see food rations during wars. For
example, a one child policy is more equitable than
allowing people to buy the rights to have children
(tax on children).

- it seems to me that powder is likely to be better than liquid
laundry detergent all else equal due to being much lighter which
reduces transport
emissions. Refilling containers of powder detergent seems to
be the greenest option. A LCA comparison could be done to
compare these.
92
7) a drawback of the tax is that lower profits leaves
firms with less finance for research and development
and adoption of low GHG technologies (ex. electric
cars, fuel cell tech.). However, tax revenue could be
used to provide marginal subsidies to incentivize firms
to reduce their GHGs.
- multiple policies can be used simultaneously. For
example, we could tax carbon dioxide emissions and ban
plastic laundry scoops sold and place limits on fossil fuel
extraction rates while putting floors on the amount of
natural ecosystems and their quality.
- we will revisit this when we look at direct regulation of
emissions. The arguments will be similar.
93
5_ Direct Regulation of
production units which
provide positive GHG
Externalities

http://www.cbc.ca/news/canada/british-
columbia/story/2010/12/09/bc-forests-carbon-dioxide-
report.html
94
Recall that we are looking at policies to correct market
failure due to GHG externalities with a focus on policies
which target output of either goods, services or inputs.
In the last section, we investigated policies which target
output of goods which cause negative GHG
externalities (ex. gasoline).
Here, we will investigate policies which target outputs of
goods which cause positive GHG externalities.
What is a good which causes a GHG externality?
Give an example?
- the concept of a “policy target” is important here. Recall our
gasoline policy was levied on the gasoline itself. An alternative
would be to target
the GHGs themselves -- next lecture.
95
5.1_ Backgrounder on
Ecosystem Sinks as ex. of
goods which provide
positive externalities.

report.html
Ecosystems provide
essential services
like CO2 removal
from atmosphere.
- Recall that
deforestation caused
net emission of
~ 9.25 gigatonnes in
2009.
96
Equity
&
Human
Wellbeing or
“Ultimate Ends”
Economy,
Technology, Politics
& Ethics or
“Intermediate Means”
Natural Environment or Ultimate Means
Herman
Daly’s

Triangle
- Herman Dalyʼs triangle draws attention to the fact that our
human civilizations with our human production systems depend
on the natural
systems. Both the human production systems and the natural
ones, the functioning of which we determine by our decisions,
provide us with
goods and services. For example, the natural systems provide
us with oxygen, nitrogen fixation and carbon dioxide removal
services.
- Grab shot from economics lecture by Herman Daly available
here:
http://vimeo.com/11507591 (excellent lecture--Daly was head
Environmental Economist at the World Bank and is perhaps the
most famous
founder of the field of “ecological economics”). Unlike Daly,
some ecological economists do not understand neoclassical
economics.
97
The natural systems like this forest provide humans with
many thneeds like oxygen production and carbon dioxide
removal and nitrogen fixation. Natural systems currently
absorb about 50% of anthropogenic GHG emissions.
When humans decide to conserve, repair and expand natural
areas, we are deciding to produce natural goods, services
and inputs--”natural thneeds”.
Source: Natural Resources Canada

98
When this Boreal forest and lake system
is converted to human uses to produce
thneeds such as...
Source: Natural Resources Canada
99
synthetic crude oil, we loose the natural
goods and services, the carbon dioxide
renewal services and the many other
services which nature provides us with.
- Estimated 315 billion barrels of recoverable crude oil with 175
to 200 billion barrels privately economically recoverable using
current
technology.
- mining and processing bitumen to form synthetic crude
releases 0.075 tonnes CO2e/ barrel (source
- GHG footprint mining and processing Canadian Tar Sands:
= 0.075 CO2e/barrel *(175 - 200 billion barrels) =13.125 - 15
tonnes CO2e
- At carbon price of $50/barrel, this is an external cost of $
656.25 - 750 billion ( bit more than a 3rd of annual GDP).
-At a carbon price of $100/ tonne CO2e, the number rises to
$1312 - 1500 billion (almost our annual GDP)
-At a carbon price of $200/tonne CO2e, the number rises to
$2624 - 3000 billion (almost 2 years of annual GDP)
Note: most of the footprint is further down the supply chain
when the final fuel is combusted. So, the full lifecycle analysis
(LCA) footprint is

about 4.5 the above number (ignoring the sinks) = 2952 - 3375
bill (at the low $50/tonne carbon price) or 11800-13500 at the
$200/ tonne price
(7 - 8 years of Canadaʼs GDP).
- Data from Canadian Energy Board and Sharpe, A. et al. The
Valuation of the Canadian Tar Sands, Centre for the Study of
Living Standards.
- No permissions for image of Tar (Oil) Sands obtained/ used
under Dalhousie Copyright Agreement for fair use. Other
photos available here:
http://www.edwardburtynsky.com/WORKS/Oil/Oil_Sands_Larg
e/OLF_ALB_11_07_big.jpg
100
1750 - 3000 tonnes CO2
per hectare of land
(boreal forest sink lost
to wetlands #)
= 80 to 150 typical
Canadian yearly
footprints (20 tonnes/yr)
- To get the total footprint, we would need to figure out what
portion is strip mined vs. what portion is mined using cyclic
steam stimulation (which
does not result in this massive damage) and multiply by
footprint estimates for each type (mining shown here vs cyclic
steam stimulation which
injects the steam underground).
- It is difficult to estimate the rate of success of land
reclamation activities at this point in time. A small amount of
land has been reforested but

the land type has completely changed from wetlands and boreal
forests (the best carbon sinks) to a sandy highland.
101
Other anthropogenic causes
for damages to Canada’s
carbon sink forests include:
- agriculture
- forestry,
- human residential and
industrial building & roads,
mining.
- global warming causing...
a) tree eating beetles and
moths able to survive
winters further North,
b) increased incidence of
forest fires
[ positive feedback loops]
- these are positive feedbacks of global warming.
- warming causes forest fires, which causes a net release of
GHGs into the atmosphere causing more global warming and
more forest fires and
so on.
102
2004:

The Forestry sector is
responsible for 17% of total
greenhouse gas net emissions
globally.
- deforestation (carbon sink
destruction) = 6 Gt CO2e/year
- decomposition logging debris,
peat fires, peat decay = 2 Gt
- reforestation = - 3.3 Gt
Net emissions forestry
= 5.7 Gt/ year.
Forests give positive
externalities!
- Data Source: Kump and Mann (DP), Pg. 174 - 175. Based on
UN
IPPC FAR.
- Country trends on page 175.
- Balsam firs are an important tree species in Acadian Coastal
Forest
Ecosystems.
103
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soil = rose
plants = blue
- Accounting for changes in atmospheric GHGs due to
land use, land use change and forestry (LULUCF) is
complicated with uncertainty in numbers.
tonnes
CO2/ha
104
Enhancing Forest Health to increase its carbon sink
Capacity is an important way to slow global warming.
Alberta
-This map illustrates estimates of flows of CO2/year of the
Canadian land mass.
- The numbers are in units of carbon (atomic weight = 12 amu).
To convert to carbon dioxide weight (44 amu), multiply the
numbers by 44/12 =
3.77. Ask me to go over this in class.
- This slide shows flows of CO2 while the previous slide shows
the amount that is stored (stocks). We can see that stocks are
much bigger.
Carbon accounting for LULUCF is complicated and there is
large uncertainty, yet measures are improving.
Alberta map Source: http://en.wikipedia.org/wiki/Oil_sands

- According to Natural Resources Canada, Canadaʼs managed
forests oscillate between being net sinks and net sources of
emissions.
Source Map: Chen, Jing M. (2003) Spatial Distribution of
carbon
sources and sinks in Canadaʼs forests, Tellus, 55B, 622 - 641.
http://
faculty.geog.utoronto.ca/Chen/Chen's%20homepage/PDFfiles/
p71_chen_tellus_b55.pdf
105
- Also, forest destruction causes many other externalities than
just the destruction of natural carbon sinks. They provide
habitat for many
species like this common redpol. When forests are destroyed
for farming, forestry, industry and residences and roads, natural
ecosystems
shrink. Humans need ecosystems upon which to recycle the
building blocks for the living systems of which human beings
depend.
- To estimate a monetary valuation of the positive externalities
from forests, we would need to figure out the carbon sink
capacity and then
multiply this by the carbon price. We would also need to
consider all other ecological benefits like nitrogen recycling,
oxygen production and
also put a value on species like this common redpol (a
somewhat dubious exercise).
106

Hairy Woodpeckers
- These Hairy Woodpeckers are medium sized woodpeckers and
have similar markings to the smaller Downy Woodpeckers.
There are also
much bigger Piliated Woodpeckers (these are the ones with the
great red crest). I saw a piliated woodpecker on two occasions
as a child.
- Once, massive Ivory Billed Woodpeckers, inhabited the forests
of the Western USA. These birds were reported to be so large
and fantastic
that people would call them “Oh Lordy Birds” because this is
what people would say if they saw one, so amazed were they by
its splendor. The
Ivory Bills went extinct in the 20th century. Cause:
Anthropogenic. Source of this story: Barbara Kingsolver, “The
Lacuna”
107
5.1_ Pigou’s model of
positive externalities.
report.html
108
- Lets model a naturally produced thneed (here
a natural forest) which produces positive

externalities as a byproduct of the human
decision to allow the natural system to operate in
this land area.
- While it may seem strange to think of the
demand and supply of natural forests and
wetlands, humans are ultimately in charge of
deciding how much natural forest we provide.
- It can make sense to think of natural
ecosystem production systems as part of the
economy.
- Ex. demanding forests = donate money to a nature trusts which
buy
up forest lands to protect them, or people replacing lawns with
forests,
carbon forest offsets (to be discussed later) or through voting
for
governments with green platforms and influencing governments
(ex.
write letter) to put into place Pigouvian regulations.
Natural
Forest
(km2/period
$ / km2
20
0
0

100 $M
C
Pri
va
te
$ MB Private
QSE
= 15
Pm = 60
Qm = 40
MBExternal
= 50
Find SE allocation with a positive externality
This is the marginal
opportunity cost of
having a natural
forest (ex. cut it down
for the wood or mine
the land under it)
- Lets model a naturally produced thneed (here a natural forest)
which
produces positive externalities as a byproduct of the human
decision
to allow the natural system to operate in this land area.
- For simplicity, we assume that there are no negative
externalities
from the forest. Assume marginal external benefits are $50 per

km
sq. natural forest.
Natural
Forest
(km2/period
$ / km2
20
0
0
100
$M
C
Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
The Market for forests fails to produce the socially
efficient amount of forest. The price is too low and quantity

too low. 150
MBExternal
= 50
$ MB social
PSE = 85
$M
C
So
cia
l
- Add the marginal external benefits to the marginal private
benefits (marginal willingness to pay) to get the marginal social
benefits. MBsocial = 100 - Q + 50 = 150 - Q
- Since, I assumed no marginal external costs, the marginal
social costs are equal to the marginal private costs.
MCsocial = 20 + Q + 0 = 20 + Q
- Find the SE level of output. This is the level which
maximizes the total social surplus = total social benefits - total
social
costs.
Set: MB social = MCsocial ==> 150 - Q = 20 + Q ==> Qse =
65 km sq / period.
Plug back into MCsocial or MBsocial equation to get the
socially efficient price, Pse = $85/kmsq.
- think of social MB as the marginal willingness to pay (MWTP)
of society as a whole (including future generations) to conserve
natural forests. This is higher than the private MWTP
($MBPrivate ) because private parties will fail to take into
account positive
externalities when deciding how much forest to provide.

Natural
Forest
(km2/period
$ / km2
20
0
0
100
$M
C
Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Show that the SE allocation maximizes TSS at Qse but not
at Qm so market fails
150

$ MB social
PSE = 85
A
B
C
D
E
F
G
H
I
J
$M
C
So
cia
l
- Recall that to do this, you must identify areas under marginal
graphs
which correspond to respective totals.
- Find total social benefits at Qse.
- Find total social costs at Qse.

- Find total social surplus at Qse. (area between
Natural
Forest
(km2/period
$ / km2
20
0
0
100
$M
C
Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Find Total Social Benefits (Qse)
150

$ MB social
PSE = 85
A
B
C
D
E
F
G
H
I
J
$M
C
So
cia
l
- Total social benefits at Qse = A+B+C+D+E+F+G+H+I+J
Natural
Forest

(km2/period
$ / km2
20
0
0
100
$M
C
Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Find Total Social Costs (Qse)
150
$ MB social
PSE = 85
A

B
C
D
E
F
G
H
I
J
$M
C
So
cia
l
- Total social costs at Qse = F + J + I (there are also total
private
costs, i.e. all the paid inputs)
Natural
Forest
(km2/period
$ / km2

20
0
0
100
$M
C
Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Find Total Social Surplus (Qse)
150
$ MB social
PSE = 85
A
B
C
D

E
F
G
H
I
J
$M
C
So
cia
l
- Total Social Surplus = Total social benefits - Total social
costs
(A+B+C+D+E+F+G+H+I+J) - (F + J + I) = A+B+C+D+E+G+H
Question: Now find the total social surplus for the market
allocation and
show it is lower. Check your answer using the next few slides.
Natural
Forest
(km2/period
$ / km2

20
0
0
100
$M
C
Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Find Total Social Benefits (Qm)
150
$ MB social
PSE = 85
A
B
C
D

E
F
G
H
I
J
$M
C
So
cia
l
- Total social benefits at Qse = A+B+C+D+E+F
Natural
Forest
(km2/period
$ / km2
20
0
0

100
$M
C
Pri
va
te =
$M
C
So
cia
l
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Find Total Social Costs (Qm)
150
$ MB social
PSE = 85
A
B
C

D
E
F
G
H
I
J
- - Total social costs at Qse = F (there are also total private
costs,
i.e. all the paid inputs)
Natural
Forest
(km2/period
$ / km2
20
0
0
100
$M
C

Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Find Total Social Surplus(Qm)
150
$ MB social
PSE = 85
A
B
C
D
E
F
G
H
I

J
$M
C
So
cia
l
- Total Social Surplus = Total social benefits - Total social
costs = (A
+B+C+D+E+F) - (F) = A+B+C+D+E
- We can see that the total social surplus is lower at the market
allocation
in comparison to the SE allocation by area G+H which is the
deadweight
loss of the market. As with a negative externality, when a good,
service or
input causes a positive externality, the market fails.
- With the negative externality (ex. bitumen), the market
produces too
much and the price is too low while with positive externality
(ex natural
forest), the market produces too little and the price is too low.
118
5.3 How can we correct a market
with a positive externality?
- As with the negative externality causing thneed
(gasoline) we will now consider the price and the
quantity mechanisms to provide the socially

efficient amount of forest.
Qualities also need to be considered. Ex. boreal
forests store more carbon dioxide than tropical
rainforests, yet the latter contain vastly more
biodiversity.
- As the negative externality, we will consider the price and the
quantity mechanisms. Qualities also need to be considered.
For example,
some land will be more suited for highly productive forests than
others. A section of forest which is home to an endangered
species would also
need to be a priority.
- As climate changes, ecosystems will change as warm tolerant
species are able to migrate further North. Maintaining North-
South forest
corridors which enable species to move is important. Its
especially important to conserve forests around riparian zones
due to symbiotic
relationships between terrestrial and aquatic ecosystems. For
example, bears leave fish carcasses in the forest and also their
dung. Hence,
the ocean provides fertilizer for the forest. The nutrients from
the forest run into the rivers and are delivered to the oceans and
lakes enhancing
their productivity.
Natural
Forest
(km2/period
$ / km2

20
0
0
100
$M
C
Pri
va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Marginal Subsidy = S
150
$ MB social
PSE = 85
$M
C
Pri
va

te - S
Price Mechanism:
- If we pay the firm a subsidy (S) of $50 per km sq of natural
forest, its
private marginal costs fell by $50/ unit and so the supply curve
shifts
down by this much.
- Now human production units can afford to produce the good
(here
forests) at a lower price. Due to the lower price, the demand for
forests
rises and we move along the demand curve so more forest is
provided
in equilibrium.
Natural
Forest
(km2/period
$ / km2
20
0
0
100
$M
C
Pri

va
te
$ MB Private
QSE
= 65
Pm = 60
Qm = 40
Set Floor on amount of natural forests
150
$ MB social
PSE = 85
Quantity Floor
Quantity Mechanism:
- A quantity floor is the opposite of the quotas we discussed
(which are also quantity
ceilings). The floor provides a minimum on the amount of
forest that must be
supplied. Quality conditions can also be specified. For
example, a section of
Northern Madagascar contains the 19 last individual members of
the Northern
Sportiff Lemur species which are almost extinct. This forest
could be preserved
under a quality criteria of prioritizing habitat of species that are
highly endangered.
Given that lemurs are primates with which humans recently
share ancestors (about 63

million years ago), I think that the conservation of this species
should be a massive
global priority.
121
5.4- Removal of
Inefficient Subsidies on
Fossil Fuels
Socially Efficient
Quantity of
Thneeds/ period
$ / thneed
20
0
0
100
Qm = 40
Pm = 60
$M
C

Pr
iva
te
$ MB Private
= $ MB Social
$M
C
So
cia
l
QSE
PSE
Private
Efficiency
A
Qsubsidy = 40
$M
C
Pr
iva
te -
S

Allocation
with subsidy
B
- Unfortunately, instead of taking the advise of economists, to
raise the
price of goods which create GHG byproducts, the fossil fuels
are often
subsidized. Returning to our original example of the thneed
(like the
bitumen) which produces a negative externality, suppose that
the
government mistakingly gives the bitumen company a subsidy
of S. This
shifts the supply curve downwards so that the firms prices are
driven
downwards. When prices are lower demand increases (move
along
demand curve) so more bitumen gets sold and more GHGs are
produced.
Now the deadweight loss has grown from A under the market
allocation to
A+B in the subsidized situation.
123
6- Equity
Pigouvian policies whether falling on goods, services, inputs or
on
greenhouse gas byproducts will affect people differently.
For example, suppose you emit 10 tonnes of CO2/year and the
carbon tax is $25/tonne CO2e (as in Australia), your

yearly carbon tax will be 10 *25 = $250/year. It the
tax was $100/tonne, your yearly tax is $1000.
Middle and High income Canadians will not be hurt much by
this
tax unless they have gigantic footprints.
However, low income people will take a hit here even in
Canada. To compensate these people for the tax, lump sum
rebates and progressive income taxes are required. The
problem is even larger on a global scale due to such great
income
disparities.
- That said, income is highly correlated with greenhouse gas
emissions per capita such that high income people will pay more
tax. Also,
damages are expected to harm low income people more heavily
than high income people (especially in global South). Hence,
not doing
anything about global warming would be highly inequitable too.
124
7- Summary:
- Given our current technologies, most consumption goods
provide
net private benefits (surplus) but also external costs due to
their effect upon environmental quality.
- Economists have the goal of making society a better

place and use criterion such as social efficiency and equity to
evaluate various options.
- Under the $ social efficiency criterion, economists choose
the number of consumption goods that maximizes the total
money social surplus (total social benefits of a consumption
good
minus the total social costs). Social costs have two categories,
private and external costs. Social benefits are likewise private
or
external.
- Markets fail to be socially efficient when there are
externalities. For example in the case of negative
externalities, the market price is too low and the market
quantity too high for social efficiency. In the case of positive
externalities, markets tend to provide too little of the good
and the price is too low.
- Since markets fail, economists want to regulate the market
to make it behave “better” according to “social welfare
criterion” such as monetary social efficiency and
equity.
- There are three basic types of policy targets, quantity, price
and
quality. We looked at examples for regulating negative
externalities including a quota on output (an example of a
quantity instrument) and a tax on output (an example of a
price instrument).
- It is best to target policy along supply chain where GHGs are
released, not just on final stage.

- To regulate goods like forests which provide positive
externalities, we can use the quantity mechanism of a
floor or a price mechanism of a subsidy.
- Quality mechanisms include standards on allowable
technologies including sustainable forestry and building codes.
- We looked at policies to regulate markets guide them to
produce the socially efficient quantities and qualities
of output (TSS is maximized). The externalities are said to be
“internalized” such that the users (consumers and producers)
pay for negatives and are subsidized for positives.
- The monetary total social maximizing goal may
disproportionately harm low income people, income
redistribution policies like income tax reductions on low
and middle income people will need to be simultaneously
implemented. These may provide compensation while still
providing incentives to reduce GHGs since GHG intensive
goods
will be relatively expensive.
- Economists often recommend targeting byproducts like
GHGs directly instead of goods, services (like electricity
or cars). This approach has the merits of enabling firms to find
the most cost effective methods to reduce emissions (we look at
this in the next lectures).
- However, regulating goods, services and inputs may be the
simplest regulation in some cases. For example, in the case
of cars, it is much easier to tax gasoline than GHG
emissions. Regulating goods, services and inputs can also
potentially be rapidly implemented.

“Thneeds” Residual
Byproducts
inputs services goods
Forests provide
CO2 removal
services
C
ru
d
e
O
il
- crude oil, trees
for paper and
wood, includes
technologies
- transport
to work
- trees as an
end product
Next Class, we shift our focus away from markets in GHG
intensive goods and services to the GHGs themselves.
We will develop the MAC MD framework which will allow us
to

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